atLaw
Robert E. Richards, Jr.
617 226-3421
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You know that you want to structure your new business to limit your personal liability, but you’re not quite sure what form your new business should take. Should your business be a limited liability company (“LLC”) or a corporation? If you choose the corporate form, should your business be a traditional corporation, commonly referred to as a C-corporation, or be a corporation electing to be treated as a partnership for tax purposes, commonly referred to as an S-corporation? The answers to these questions depend on your ultimate business objectives.
This article examines and assesses various characteristics, advantages and disadvantages of the corporate and LLC forms for doing business.
The C-corporation and S-corporation offer very similar characteristics with the exception of tax treatment. Each offers limited liability and a well-defined body of supporting law that provides clear guidance regarding corporate governance, fiduciary duties and general rules of the game for all participants. The significant difference is how each entity is treated for federal income tax purposes. Federal tax treatment for C-corporations taxes the corporation separately from its stockholders. Its earnings are therefore subject to double taxation, first at the corporate level, and then again to the stockholders upon receipt of dividends or distributions. On the plus side, C-corporations offer flexibility in the form of equity owner-ship and transferability of shares.
Conversely, the S-corporation is treated as a pass-through entity for federal income tax purposes. Therefore, its earnings are subject to taxation only once at the stockholder level. However, the S-corporation is subject to certain rigid restrictions reducing flexibility in ownership structure. For instance, the S-corporation may have no more than 100 stockholders, and is prohibited from issuing more than one class of stock (although the class may have different voting rights). And it is prohibited from having its shares held by pension plans, nonresident aliens and other legal entities.
An LLC is much like a corporation. All states have enacted LLC statutes, which afford its members (those with an ownership interest) limited liability protection like that of stockholders of its corporate counterpart. Also, the LLC pro-vides significant flexibility in equity ownership for its members, at least equal to the C-corporation. While LLC statutory provisions supply default provisions regarding LLC governance, members can enter into an operating agreement tailored to their needs that supersedes the statutory default provisions. Similar to the S-corporation, LLCs are not taxed at the entity level, but rather income or loss from the LLC flows directly through to the members and is recorded on their individual tax returns. However, unlike the S-corporation, an LLC does not have limitations on the number and type of holders of ownership interests and the ability to issue such interests with different classes, rights and priorities. Because LLCs are so new (in existence in Massachusetts since 1996), there is not yet a well-defined body of administrative and case law to guide LLC on issues of members governance, fiduciary duties, and tax consequences of certain transactions.
I. Limitation on Liability Protection
Limited liability encourages capital formation and innovation. Fewer individuals would be willing to invest in an entity if such investment would the investor’s personal assets at risk upon the entity’s failure or for other liability attributable to the entity.
A. The Corporation
The liability protection afforded by a corporation (for both S- and C- types) is among its most important features. A corporation is a separate legal entity, distinct from its owners, and as such, is liable for its own debts. In most cases, stockholders of a corporation are liable only to the extent of their investment in the corporation, and not for the liabilities or obligations of the corporation. As a result, creditors may not reach the personal assets of the stockholders of the corporation except in very limited circumstances, usually involving fraud or irregular corporate practices.
Courts have “pierced the corporate veil” to reach individual assets of share-holders in circumstances where some or all of the following factors are present: (a) the corporation has failed to maintain adequate corporate records or to comply with corporate formalities; (b) corporate owners have commingled personal and corporate funds or assets; (c) the corporation has been undercapitalized or insolvent; and/or (d) the corporation has been acting merely as an “alter ego” of its stockholders.
While unusual, directors and officers of a corporation can also be subject to personal liability for their actions or inaction as directors and officers. Such liability is typically attributable when corporate officers or directors act in violation of their duties to the entity or exploit the entity for personal gain.
B. The LLC
Generally, every state’s LLC statute pro-vides members with liability protection akin to stockholders of a corporation. Members of an LLC are viewed as being separate and distinct from the LLC entity itself and are afforded liability protection except in certain, limited circumstances.
Although LLC case law is still developing, it is reasonable to assume that courts will pierce the LLC veil in circum-stances similar to those described above for a corporation.
II. Organization and Operation
A. Corporation
Each state’s corporate statute sets forth the procedural requirements for establishing a corporation. A corporation’s articles must contain such information as its name, purpose, series and/or classes of capital stock, and additional provisions such as indemnification, and a listing of officers and directors. In addition to the foregoing information, each corporate statute requires not only an initial incorporation fee, but also requires that each corporation pay an annual corporate maintenance fee and/or file an annual report to remain in good standing.
After establishing corporate existence, a corporation will also be governed by state statute for rules that allocate power and define governance within the corporation. The corporate governing structure is comprised of the stockholders who own the corporation and the board of directors who oversee the management of the corporation. The board of directors must be elected annually by the stockholders. The board sets policy and elects the officers of the corporation, who are then charged with the implementation of such policy and the day-to-day management of the corporation.
Massachusetts corporate statutes require that a corporation have at least the following officers: a President, a Treasurer and Secretary (which can all be the same person). A corporation’s bylaws may also provide for other officer positions and titles.
Certain extraordinary corporate acts, such as mergers or sales of substantially all or all of the corporation’s assets, must be approved by the directors and a prescribed percentage of the stockholders. In addition, certain amendments to the corporation’s charter documents also require approval by the directors and a certain percentage of the stockholders.
B. The LLC
An LLC is formed by filing with the Secretary of State’s Office a certificate of formation, a document bearing surprisingly minimal information about an LLC. For example, Delaware merely requires that the certificate of formation include the name, the address of the registered office and the name and address of the registered agent for service of process. Massachusetts requires more—that the certificate of organization include the LLC’s Federal identification number, name, registered office, primary business, anticipated date of dissolution, agent for service of process, manager, if any, and the name(s) and address(es) of any person who is able to execute documents to be filed with the Secretary of State and Register of Deeds within the Commonwealth of Massachusetts.
The governing document of an LLC is an operating agreement (in Massachusetts), or a limited liability company agreement (in Delaware). Although most LLC statutes do not require a written operating agreement (Delaware does require a limited liability company agreement), it is ordinarily important that the members of the LLC expressly set forth in writing the terms of the operation of the LLC. Without a written agreement or when such agreement is silent on a particular issue, the operation of the LLC will default to provisions of the LLC statute.
The LLC can promote flexibility in governance through a well crafted operating agreement. Generally, the operating agreement describes whether the LLC is to be managed by its members or a manager appointed by the members; its business purpose; manager and member rights; obligations and duties regarding the LLC’s business; transferability of LLC interests; allocations and distributions of profit and loss; and dissolution and dispute resolution provisions.
III. Equity Compensation Arrangements
A. Corporation
A corporation may offer stock-based incentive compensation arrangements to directors, officers, employees, consultants and advisors, among others. In addition, the corporate arsenal of employee incentives may include ISO’s (incentive stock options), nonqualified stock options, restricted stock and phantom stock (including stock appreciation rights, or “SARs”).
Only a corporation may grant incentive stock options. They are similar to nonqualified options but offer more favorable tax benefits to employees if the requirements of the Internal Revenue Code are met. Assuming an employee has held the stock for the requisite one year after exercise of the option, the main tax benefit of an incentive stock option to an employee is that the difference between the price paid to acquire the stock upon exercise of the option and the fair value of the stock at the time of exercise is taxed at the favorable capital gains tax rate (and not at the much higher ordinary income tax rate). Further, any tax assessed on such exercise is deferred until the stock is sold by the employee.
Nonqualified options give employees the right to purchase the corporation’s stock at a specified price at some point in the future. Generally, neither the corporation nor the employee will recognize any tax upon the grant of the nonqualified option. Upon exercise of such options, an employee will be taxed at ordinary income rates (and not capital gains rates) on an amount equal to the difference between the then fair market value (or sale price) of such stock less the exercise price.
Restricted stock issued to an employee provides him or her with immediate stock ownership, but in many cases remains subject to vesting provisions set forth in the award agreement. If, in the eyes of the Tax Code, there is a substantial risk that the employee will forfeit the stock under vesting or repurchase provisions of the award agreement, the employee will be taxed at the time the risk of forfeiture lapses at the current value of the stock (usually much higher from the date at issue). To avoid this result, the employee may file an “83(b) election” and pay the tax on the value of the stock at the time of filing. The downside of filing an 83(b) election, however, is that the stock can decline in value and an employee risks losing the tax paid on the restricted stock if he or she does lose the stock under the vesting or repurchase provisions. Additionally, if the employee pays for the stock with a promissory note and the stock declines in value or the corporation fails, the corporation’s creditors can require the employee to pay the outstanding balance owing under the promissory note even though the underlying stock is worth less or even nothing at all.
Phantom stock is essentially a promise by the corporation to pay to an employee a bonus based upon some measure of value of the corporation. For example, the corporation may agree to provide an employee with a bonus equal to a specified percentage of the increase in the corporation’s value during any given year. Stock is not actually granted, rather phantom stock is a contractual right to share in some measure of the corporation’s success.
When a business intends to utilize equity as incentive compensation, a corporation is the most efficient vehicle. Further, if a business intends to issue employee-friendly incentive stock options, then the entity of choice must be a corporation.
B. The LLC
Like a corporation, an LLC can issue nonqualified options, restricted equity interests and phantom equity interests, but unlike a corporation, an LLC cannot grant tax-favored incentive stock options. However, the use of such incentives can create complicated tax and accounting issues for an LLC which do not occur with a corporation and will require input from a tax professional.
III. Conclusion
A. Corporation
Among business forms available, corporations offer a well-developed body of law in addition to liability protection, including clear guidance to directors and shareholders regarding corporate governance, fiduciary duties and general rules of the game. The corporation can also and more efficiently deliver various forms of stock-based incentive compensation to employees without the risk of adverse tax consequences, or additional administrative costs as with an LLC.
The pass-through tax treatment of S-corporations can offer a simple yet effective alternative for an individual who has decided upon the corporate form and is able to operate the business without capital from outside institutional investors. Since an S-corporation is precluded from issuing more than one class of capital stock and is severely restricted as to the persons and types of legal entities qualified to hold its stock, the S-corporation is not an option for a business requiring outside institutional capital. When raising outside capital is foreseeable for the business, a C-corporation is the most appropriate of the two corporate choices. The C-corporation provides substantial flexibility in the issuance and transfer of its stock, including by series and by class and different voting and liquidation preferences, thereby better enabling the corporation to raise capital and to tailor itself to the diverse needs of capital markets.
The downside of the C-corporation is the potential for double taxation in the event that either the business becomes successful and generates significant revenue, or it sells all of its business assets in a taxable transaction.
B. The LLC
Alternatively, an LLC is advisable if owners seek to avoid double taxation of distributable earnings or wish to al-locate profits or losses to its members in differing amounts each year. These favorable tax opportunities by themselves often justify organizing as an LLC rather than a corporation.
Further, an LLC offers similar liability protections, and much more flexibility than an S-corporation in terms of how its equity and governance can be structured through an operating agreement. An LLC also can offer various forms of incentive compensation such as nonqualified options, restricted equity interests and phantom equity interests, but the cost and administration of such awards can be prohibitive, and an LLC cannot grant incentive stock options to its employees.
Setting and prioritizing business objectives will ultimately drive your choice of business entity. While many of the key considerations are presented here, consultation with your attorney and tax advisor will help you choose the right mix of protection, flexibility and opportunity for growth to allow your business to flourish.
